Tuesday, 4 July 2017

Hong Kong Sets the Tone for Credit Rating Agency Liability: A Sign of the Times?

Today’s post reacts to a recent ruling in Hong Kong concerning
the categorisation of the outputs of credit rating agencies, which of course is
a pressing issue – the removal of the protection afforded by the categorisation
of ratings as ‘opinions’ has massive connotations for the regulation of the
industry and also the civil liability that the rating agencies may face. Credit
rating agencies have, essentially since they came into commercialised existence
in the mid-19th
Century, been protected by the notion that every element of their output
constitutes an ‘opinion’,
whether that be in the form of reports, or actual credit ratings. However, whilst
there is a widespread understanding that this protection is not deserved nor
appropriate, the agencies have managed to maintain this shroud of
impenetrability, even when
facing a legislative assault on that protection with the Dodd-Frank Act of
2010. Yet, a recent
case heard in Hong Kong’s Court of Appeal came to the conclusion that this
shroud should be lifted, and that the output of rating agencies, whether
defined as credit ratings or not, should be categorised as credit ratings and
regulated accordingly because, ultimately, the agencies’ outputs have an effect on the marketplace which makes
any differentiation misleading and makes regulation ineffectual. This is of
interest because the leading rating agencies are seemingly on a conflictual
path with certain nation states, and any insinuation that ‘reports’ by
these agencies should be regulated as credit ratings will add fuel to the fire
of nations like Russia, China, and India who are constantly feeling the
negative effects of these ‘opinions’.

It will be important to examine the technicalities of the
ruling before we extrapolate. The issue at hand was the dissemination of a
report by Moody’s entitled “Red Flags for
Emerging-Market Companies: A Focus on China” which, according to Moody’s
Counsel, Mr Huggins, ‘did
not express any opinion primarily on
the creditworthiness of the companies concerned’. The reason why Mr Huggins
was at pains to make this point clear was because the Securities and Futures
Commission (SFC) had initially investigated this ‘Red-flags’ report – a report
which detailed the categorisation of ‘red’ flags’ in terms of weaknesses in
corporate governance, risky or opaque business models, poorer earnings,
auditing concerns, and rapid growth, and applied these categorisation to 49
Chinese companies – and had concluded that Moody’s had failed to meet its
mandate of having ‘the required procedural safeguards in place’, which meant
the report was ‘materially
misleading, confusing and inaccurate’. The SFC had decided upon a public
reprimand and a $23 million fine, which was subsequently reduced to $11 million
by a Tribunal. The rating agency, however, was challenging the decision
because, rather than attempt to avoid the fine, the real damage would be caused
by the precedent created by the case. The Tribunal had found that the
readership was likely to perceive the report as an addendum to credit ratings
and take action accordingly, which the SFC confirmed when it stated that
although the report was not solely at fault for the deterioration in the share
prices of the targeted companies, ‘it was a significant contributor’. For the
Court, the key legal question was
whether the report, which only focused on corporate governance and accounting
risk, could be constituted as an ‘opinion on creditworthiness’ which would,
usually, contain a number of other elements. In debating this issue, the Court
ultimately ruled that even though it differed with the Tribunal regarding the
understanding that the report constituted a ‘credit rating’, it dismissed
Moody’s appeal on the basis of credit ratings do not, necessarily, have to be
on an ordinal scale anyway – in layman’s terms, the Court of Appeal agreed that
the report was misleading, confusing, and inaccurate, but that it was wrong to
conclude that the report itself constituted a credit rating. The terminology
may have been set, but the Court’s ruling that ‘misconduct
can be established on the basis that the preparation and publication of the
Report was part and parcel of the carrying on of the business of credit ratings
by Moody’s’ is likely to have quite an effect on the operations of leading
agencies outside of the U.S.

This finding, that the report had an effect on the targets and could be perceived as part of the
agency’s output, puts the entire notion of ‘opinion’ under direct threat and,
quite frankly, it is a much needed development. The antebellum United States
presented an arena whereby the rapid expansion of the Country, via the railroad
system, meant that merchants could not judge the creditworthiness of supplies
or consumers accurately any longer. In this sense, the rating agencies were
vital and, owing to their subscriber-pays remuneration system, were in need of
statutory protection to continue. However, that arena no longer exists and the
agencies have gone from being a public ‘good’ to being a social hazard. The
ability to affect the standing of an entity, without even producing a
recognised ‘credit rating’, has elevated the agencies into the position of
‘kingmakers’, a position which they very much enjoy – this is in direct
contrast the level of the useful information they actually impart. So, with
that understanding in mind, the ruling in Hong Kong presents the potential – and that is all it is at
this moment – for a change in emphasis around the world with regards to
regulating credit rating agencies, and that is why Moody’s sought to challenge
the initial ruling of the SFC. Essentially, the tone has been set to hold the
rating agencies to account for all of
their output, not just their credit ratings, and that revolution is vital if we
are to be spared from another financial collapse that has the rating agencies
at its facilitative centre... again.

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